“Passive investing is worse than Marxism.” That’s according to analysts at research and brokerage firm Sanford C. Bernstein & Co in a recent paper that has sparked one of the hottest debates in the ongoing active-versus-passive conversation.
Broker Sanford C Bernstein said recently in a paper that passive funds were worse for society than Marxism (Karl Marx pictured).
Bernstein said that passive funds, such as exchange-traded funds, threaten the very structure of capitalism, arguing that “a supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market led capital management.”
Allister Heath, deputy business editor of the Daily Telegraph, supported this paper by writing that although passive funds may be cheaper, they cannot drive economic growth by allocating resources to companies and entrepreneurs that need it or force change at companies by withholding investment.
“While active stock pickers and fund managers often fail their own clients, they fulfil a strong social and economic purpose,” he said.
Robin Powell, a financial journalist and educator, responded that this argument was a “fallacy”, as new offerings account for a tiny fraction of trading.
“Jack Bogle [Vanguard founder] has estimated around 1%, which means that 99% of market activity is simply active traders trading with one another,” he said.
In the meantime, active fund performance has disappointed. Hedge funds have generated 1.2% in 2016 to the end of July, falling short of the 7.6% from the S&P 500 Index.
Dimensional Fund Advisors, an asset manager and ETF issuer, also discovered by analysing the performance of 3,870 active mutual funds between 1984 and 2015 that the industry, as a whole, underperformed the Russell 3000 Index by 1.34% per year.
For better or for worse, is it likely passive funds could come to dominate?
In the last year to late June, all asset classes of long-term active mutual funds lost $308 billion, while ETFs gained $375 billion, according to Morningstar.
But despite a large shift from active funds to ETFs in recent years, ETFs still account for a modest proportion of overall assets.
Of the more than 4,600 ETFs listed around the world, the vast majority of their $3.2tn assets are tied with passive-tracking funds. In the US, the largest ETF market by far, 99% of the $2.4tn under management is linked to passive ETFs, with only a tiny proportion in active ETFs, which are struggling to gain traction.
Powell told ETF Strategy that the idea that passive funds being anywhere near dominating the asset management industry is “ridiculous”.
“Almost everywhere else in the world — including the UK — indexing has barely scratched the surface,” he said.
Craig Lazarra, the global head of index investment strategy at S&P Dow Jones Indices, disagreed with the Bernstein argument, saying that the flow of assets into passive funds are presumably flowing out of the worse performing active funds, thereby contributing to market efficiency.
And if passive funds did come to dominate, investors would once again return to active funds, according to industry participants.
Allan Roth, founder of financial planning firm Wealth Logic, told ETF.com: “While I admit I never thought 40% of money in US stock funds would ever be in index funds, I’m positive that true market-cap indexing can’t become too large. Human nature would take over, and I’d even turn to active investing.”
Sam Bowman at the Adam Smith Institute shared this sentiment.
“If passive investments became inefficient, that inefficiency would create an incentive to become an active investor,” he wrote.
The incentive to remain with passive funds is strong in terms of annual fees. Average asset-weighted fees for ETFs is 0.18% versus 0.78% for active mutual funds, said Morningstar.